TheDismalScience

I've long wanted to understand more things economical. Let's see if we can come up with an idiot's guide... Please correct any errors, confirm or refute obvious guesses, add more information, and generally improve this page.

What is money?

Ok, yeah, it is the green stuff you put in your pocket. But what backs it? Ever since the fall of the gold standard, people have argued that it is purely worth whatever people agree it is worth. That the economy is basically an illusion. A confidence trick. 1s and 0s in a computer somewhere.

People also talk about cowrie shells, and money as an abstraction of barter or promisory notes. People in online games like Diablo II saw a small, portable, rare, useful (and above all, reliably constant) item called a Stone of Jordan turned into the defacto currency for trade deals.

But somewhere the whole issue of 'fairness' creeps in. The supply and demand view of a fair price breaks down when you get price fixing cartels or monopolies. And some people reject the whole idea, and go for gift economies or local based currencies backed by hours of work however rare or common the skill being employed for that hour.

Which brings me back to my original question. What actually is money?

Inflation

What is it? When goods and services become more expensive, that's inflation. Another way to look at it is money becoming worth less.

Who cares? Inflation is bad for people with savings, because the value of their savings shrinks. But it's good for people with debts, because it erodes the value of the outstanding debt, and presumably is neutral for people who have most of their wealth held in things other than money.

What causes it? Printing money (or its electronic equivalent) makes inflation happen: if you print more euros, each individual euro shrinks in value. (What else?)

Deflation is negative inflation: goods and services getting cheaper, or (equivalently) money becoming worth more.

Interest Rates

These seem to be linked to inflation.

The effect of inflation on debts is important: if inflation is high, the outstanding value of a debt shrinks, so the lender has to charge a higher interest rate to get the same real return from lending money. But governments seem to increase interest rates if they want to reduce inflation. It works like this. When they lend money, banks add to the money supply -- the person who has the money on deposit thinks they still have the money, and the person who's been lent it thinks they have it too. So the effect is similar to printing money. With a lower interest rate, banks lend more money, so this effect is greater; with a higher interest rate they lend less, so the effect is reduced.

You can't use interest rates to reduce deflation, because you'd have to have a negative interest rate, i.e. borrowers would get paid for the privilege of borrowing money. (But printing money will reduce deflation.)